Cyclically Adjusted P/E Ratio: A Smarter Way to Value Stocks

What is the Cyclically Adjusted P/E Ratio (CAPE)?

The cyclically adjusted price-to-earnings ratio (CAPE) is a valuation metric that attempts to smooth out the fluctuations in earnings caused by the business cycle. It was developed by Yale economist Robert Shiller in the 1980s.

The CAPE is calculated by dividing the current price of a stock by its average inflation-adjusted earnings over the past 10 years. This gives a more long-term view of a company's earnings than the traditional P/E ratio, which only uses the past year's earnings.

Why is the CAPE Useful?

The CAPE is a useful valuation metric because it can help investors avoid overpaying for stocks during periods of market exuberance. When the CAPE is high, it suggests that stocks are overvalued and may be due for a correction. Conversely, when the CAPE is low, it suggests that stocks are undervalued and may be a good value for investors.

How to Use the CAPE

The CAPE can be used to value individual stocks, as well as the overall market. To value an individual stock, simply divide the current price of the stock by its 10-year average inflation-adjusted earnings. To value the overall market, you can use the CAPE for the S&P 500 index.

What is a Good CAPE?

There is no definitive answer to the question of what is a good CAPE. However, as a general rule of thumb, a CAPE of 15 or below is considered to be undervalued, while a CAPE of 25 or above is considered to be overvalued.

Current CAPE Levels

As of March 8, 2023, the CAPE for the S&P 500 index is 27.3. This suggests that the overall market is overvalued and may be due for a correction.

Historical CAPE Levels

The CAPE has been used to value stocks for over 100 years. The historical CAPE for the S&P 500 index is shown in the table below.

Criticisms of the CAPE

The CAPE has been criticized for being too slow to react to changes in the market. This is because it uses a 10-year average of inflation-adjusted earnings. As a result, the CAPE can be misleading during periods of rapid market growth or decline.

Another criticism of the CAPE is that it does not take into account the growth potential of a company. A company with high growth potential may have a high CAPE, but this does not necessarily mean that it is overvalued.

Conclusion

The CAPE is a useful valuation metric that can help investors avoid overpaying for stocks during periods of market exuberance. However, it is important to use the CAPE in conjunction with other valuation metrics to get a more complete picture of a company's value.

How to Use the Cyclically Adjusted P/E Ratio to Find Undervalued Stocks

Step 1: Calculate the CAPE for the S&P 500 index.

The CAPE for the S&P 500 index can be found on the website of Robert Shiller, the economist who developed the CAPE.

Step 2: Compare the current CAPE to the historical CAPE.

If the current CAPE is below the historical CAPE, then the overall market is undervalued. If the current CAPE is above the historical CAPE, then the overall market is overvalued.

Step 3: Find stocks with a CAPE below the market CAPE.

If the overall market is undervalued, then you can start looking for individual stocks that are undervalued. To do this, you can use a stock screener to find stocks with a CAPE below the market CAPE.

Step 4: Research the stocks you find.

Once you have found a few stocks with a CAPE below the market CAPE, you should research them to make sure they are good investments. This includes looking at their financial statements, their competitive landscape, and their management team.

Step 5: Buy the stocks you find.

If you believe that the stocks you have found are good investments, then you can buy them. Keep in mind that the CAPE is just one valuation metric. You should use other valuation metrics to get a more complete picture of a company's value.

Common Mistakes to Avoid When Using the Cyclically Adjusted P/E Ratio

Mistake 1: Using the CAPE as the only valuation metric.

The CAPE is a useful valuation metric, but it should not be used as the only valuation metric. Other valuation metrics, such as the P/E ratio, the price-to-book ratio, and the price-to-sales ratio, can provide different insights into a company's value.

Mistake 2: Not considering the growth potential of a company.

A company with high growth potential may have a high CAPE, but this does not necessarily mean that it is overvalued. When evaluating a company's CAPE, it is important to consider its growth potential.

Mistake 3: Not understanding the limitations of the CAPE.

The CAPE is a slow-moving indicator. It can take years for the CAPE to react to changes in the market. As a result, the CAPE can be misleading during periods of rapid market growth or decline.

Conclusion

The CAPE is a useful valuation metric that can help investors find undervalued stocks. However, it is important to use the CAPE in conjunction with other valuation metrics to get a more complete picture of a company's value.

Additional Resources

• CAPE Index
• Cyclically Adjusted Price-to-Earnings Ratio
• How to Use the CAPE Ratio to Find Undervalued Stocks